Waiting to be discovered
When pension funds invest in traditional assets like equities and bonds they expose themselves to unintended sources of risk. The main sources unintentional risk are volatility and dividend yield for equities and credit spreads and liquidity for bonds.
Once they detect these sources of risk most funds will either carry this risk or try to neutralise it, for example, by hedging.
However, there is a school of thought that says, by removing the risk, pension funds and other institutional investors may be throwing away a useful alpha-generating asset - a hidden asset.
Hidden assets are the darks stars of the investment universe, say their proponents. They exist but they are not visible to the naked eye of investors.
One investment bank that has been active in promoting the virtues of ‘hidden assets’ is Société Générale Corporate & Investment Banking (SG CIB). Its Global Solutions for Financial Institutions (GSFI), a team of insurance and pension specialists, is trying to encourage pension funds, their consultants and asset managers to include hidden assets in their asset allocation vocabulary.
SG CIB suggests that some hidden assets are not only an additional generator of alpha, or absolute returns, but also a useful diversification, providing lower risk for a given expected return.
European pension funds are perhaps natural clients for investment in hidden assets, since they already have hidden liabilities which they need to match. Regulatory changes and international accounting standards have put the spotlight on the valuation of company and industry-wide pension schemes’ ‘embedded options’.
These embedded options, common in continental Europe, include minimum guaranteed performance, conditional indexation and minimum annuity amounts.
Pension funds’ hidden assets are a natural match for hidden liabilities, says Yves Lehmann, a senior executive with GSFI. “Buying hidden assets such as volatility would provide a good hedge and an effective reduction of their total risk from an economic perspective.”
Yet the simple concept of hidden assets appears complex to many institutional investors, he says: “What distinguishes hidden assets from traditional assets is the fact that they look complicated. For example when we talk about the volatility smile, it puts many people off because it looks like a very complicated and sophisticated formula.
“But when you look at hidden assets as an investment, it becomes simpler. It is much easier to assess an investment like volatility or correlation, where you can analyse some time series, than predict the credit spread of General Motors, or the stock price of British Airways, which are more commonplace investments.”
Because of the apparent complexity, many traditional investors will not consider such investments, he says. “That is where there some education is to be done. Institutions are missing an investment opportunity, because those people who accept the need for education and are prepared to do a little homework will benefit largely from it.”
The starting point, from an educational point of view, is the definition of a ‘hidden asset.’ Lehmann defines a hidden asset as ”something you wouldn’t access in the market, and yet something you already access without knowing. So when you buy a classical investment you also buy the risk associated with that investment, and this risk can be measured by volatility.”
Historically, equity volatility has been the most visible of the hidden assets. With the development of variance swaps, positions in pure volatility have become possible. Implied volatilities routinely vary from 15-45%, and the markets are far from efficient.
For the past couple years, implied volatility has been relatively cheap, and therefore it made sense to buy it, especially from a portfolio perspective. Several insurers and pension funds have built long volatility positions, which have proved quite efficient, especially last May-June. Now that volatility has shot up, the investment opportunity is waning.
Yet other volatility strategies still offer potential, notably ‘volatility skew’ - the pattern of implied volatilities that occurs in the options markets, when ‘high-strike’ volatilities are lower than ‘low-strike’ volatilities.
Other rewarding hidden assets are dispersion (the volatility of a basket compared with the volatility of an index) and gap risk (the risk that the price of an investment may change with no trading occurring between the change).
One source of risk, or hidden asset, which SG CIB sources, is equity correlation. Correlation is the extent to which two or more securities tend to rise and fall together. Securities that are positively correlated will move in tandem, while securities that are negatively correlated will move in opposite directions.
Correlation will rise sharply in periods of economic or political instability and fall in periods of economic growth or when equity markets are flat. Selling correlations when they are high, therefore, is an opportunity for holders of securities to earn a high-risk premium.
Investment banks, which need to reduce their exposure to equity correlation, are natural sellers. Hedge funds, which are looking for sources of risk and arbitrage opportunities, are natural buyers.
SG CIB, a major player in equities correlation, has opened its own position to counterparties to reduce its exposure to correlation. In this arrangement the investor takes a short position on the correlation of a diversified portfolio. This means that the investor’s interest aligns with that of the bank, rather than betting against it.
One way to align the interest of bank and investor is through a hidden assets fund. Lyxor Asset Management, the structured funds platform of SG CIB, has developed a series of passive funds that invest directly in hidden assets. The investment strategy is based on a quantitative approach, involving an arbitrage between the implied and historical level of hidden assets like equity correlation and long term stock volatility.
“We took four baskets of 25 international stocks each and we designed an index,” says Lehmann. “The payout value of this index after three years corresponds to the realised correlation of all those international stocks, and the NAV of the fund tracks the index. It’s as simple as that.”
The net asset values (NAV) of the funds are guaranteed at maturity by a pre-defined formula. This ensures full transparency for the investor, he says. “If you hold the fund for a certain period of investment you know that you will be paid a certain price which cal be computed by anyone with Excel and a Bloomberg terminal.”
Unlike actively managed funds, these funds include no discretionary trading. This means that, like a tracker, the funds do not incur execution or transaction costs. “In that sense it’s a passive fund, and we consider it’s a tracker of hidden assets,” says Lehmann.
Investment in hidden assets can sit within a traditional asset allocation as easily as private equity or other alternative investments, he says. “Like private equity, hidden assets are businesses, meaning that there are ways of seeing the quality of the risk transferred.”
Yet hidden assets have one important difference from classical assets. They cannot be traded on the market. “If you could trade hidden assets on the market, the assets wouldn’t be hidden and there would be no risk premium,” notes Lehmann.
By their nature, hidden assets are a ‘buy-and-hold’ investment, he says. This makes them attractive to hedge funds who will typically buy and hold hidden assets for a period of three to five years. Hidden assets have been called the raw material of hedge funds, and hedge funds are the natural clients for the purveyors of hidden assets. They, in effect, buy the risk of hidden assets and repackage it for their retail and institutional clients, charging fees in the process. As the hidden assets risk passes down the value chain, the cost to the end user increases.
Lehmann says that although hedge funds are important buyers of hidden assets from investment banks, there is no reason why investment banks should not leap-frog them in the value chain and go straight to the institutional investor.
“We developed the business with hedge funds because they were ready to look at it,” he says. “But we found that this was not optimal for a buy-and-hold investment. In terms of value chain, we would sell a risk to a hedge fund, the hedge fund would charge its fees. At the same time we were raising assets for the hedge fund managers, since we are very active in hedge fund structured products.
“So we thought, why not go straight to the institutional investors and shorten the value chain?”
Taking these links out of the value chain means removing any active management, and Lehmann suggests that investing in hidden assets is the passive equivalent of investing in hedge funds. “The logic of direct investment in hidden assets is that the investor wants to invest into uncorrelated asset classes and sources of return but does not want any discretionary process with the fees and loss of transparency that go with this.”
Yet hidden assets are not the solution to everything, he warns. “Hidden assets are specific products, not general solutions. They can be good solutions, but it is first necessary to understand the problem.”
Pension funds have tended to look for solutions before understanding the problem, he says. Some have tried to ‘delta hedge’ their equity portfolio. This is an attempt to replicate an option, rather than buy one from an investment bank. Others have introduced constant proportion portfolio insurance (CPPI) solutions.
“When they enter a CPPI strategy they are replicating some kind of option or hidden asset in a crude form of delta hedging,” he says. “But there is a hidden cost or hidden option premium in a CPPI and pension funds need to become aware of those hidden costs.”
Lehmann and his colleagues are currently investigating cheaper alternatives to CPPIs and options. “We are really looking at the whole scope between these different instruments, and one area is the gap between constant proportion portfolio insurance (CPPI)and an option,” he says.
“There is something in between the two that is cheaper than an option and which addresses the main drawbacks of the CPPI. This area of development is generating a lot of interest today.”
It seems that, like dark stars, some hidden assets remain to be discovered.